FOREX Entry Strategies

To enter a FOREX trade, a trader must first analyze a currency pair, comprising a base currency and a counter currency. When a trading strategy indicates a profitable opportunity, a trader submits an entry price to buy or sell the currency pair. A trade will not execute unless and until the market price is equal to or more favorable than the entry price. FOREX traders use real-time trading platforms to place trades in their brokerage accounts.

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Entry Point

Traders use technical and fundamental analysis to identify a trade entry point. Exchange rates are expressed as a fraction which specifies how many units of the counter currency (the denominator) are required for one unit of the base currency (the numerator).  Rates are calculated to 1/100 of a percent; this is known as “percentage in point”, or pip, pricing. For example, a DOL/CHF (US dollar vs. Swiss franc) rate of .9507 denotes that $100,000 can be exchanged for 95,070 Swiss francs.  A trader might set a buy entry point of .9505; the transaction will not execute unless the U.S. dollar weakens by two pips.

Order Size

To manage risk, a trader will usually limit the size of any one FOREX order to some maximum percentage of available funds.  A standard contract is 100,000 units of the base currency – in our example, the U.S. dollar.  Accounts set up for min-contracts can place 10,000 unit orders, and flexible accounts can be used for any size order. An example strategy would be to limit any single order to five percent of investment funds.

Leverage

Margin is the amount of cash a trader must use to collateralize a trade – the remainder of the trade amount is lent by a broker. Leverage is the degree to which a trader will borrow trading funds. Higher leverage translates into higher risk and higher returns. A trader’s strategy will dictate how much leverage to use. Leverage levels up to 100:1 are available to risk-seeking traders, but prudent investors may limit their leverage to 5:1 or less.

Trend

Traders forecasting an uptrend in the price of the base currency relative to the counter currency will enter a position with an order to purchase the currency pair – a long position.  Conversely, a short position on a currency pair profits from a downtrend in the base currency. You establish a short position by entering an opening order to sell the currency pair.

Trade Discipline

Trade discipline helps limit losses not only from losing positions but also from failure to promptly close profitable ones. A critical strategic component of successful trading is establishing a stop-loss price coupled to the entry price. The stop-loss specifies how much loss a trader will tolerate before closing a position.  Traders quickly learn never to enter a trade without also entering a stop-loss, as the market may turn quickly against a position.  A further refinement is the take-profit order, which closes out a profitable position at a specified price.

What Is Moving Average Convergence Divergence?

Moving average convergence divergence (MACD) is a technical indicator used to identify the price trend of a FOREX currency pair, such as euro/U.S. dollar (EUR/USD). Currency is always traded in pairs: the numerator is the currency you buy, the denominator represents the sold currency. MACD is a form of technical analysis — the prediction of future prices using past data. MACD relies heavily on moving averages – the running average of the previous n-number of time periods (typically, an hour). To be more precise, MACD relies on two moving averages (“fast” and “slow”) of the difference between two other moving averages to identify a trend.

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Moving Averages

Think first of a simple average, say of the last 26 hourly prices on the EUR/USD currency pair. If you sum the prices in the collection and divide by 26, you have the average price for the collection. Let an hour elapse and do it again. What has happened is that the oldest price has fallen out of your price collection, replaced by the most recent price. Assuming the oldest and newest prices are different, the price collection will have a new average each hour: the moving average of the latest 26 periods. The effect of a moving average is to create a plotted line that “smooths” out the actual hourly price action. The greater the number of periods in the average, the slower the responsiveness of the moving average to changes.

Difference Lines

You start with two primary moving averages of hourly prices of a FOREX currency pair. The first is the average of the last 26 hourly prices; the second is the 12-period moving average. You create the fast average difference line (FADL) by subtracting the 12-period average from the 26-period average. Now, take the nine-period moving average of the FADL and you have the slow average difference line (SADL), which functions to smooth out the FADL.

Histogram

A histogram is a simple XY graph of vertical lines representing the distribution of data. Our histogram plots time on the X-axis and the differences between the FADL and the SADL (the MACD band) on the Y-axis. Superimposed upon the two average difference lines, you will notice that the height of the MACD band will shrink (converge) and grow (diverge) periodically over time. This is the key to interpreting MACD. Note that the different price collections (9, 12 and 26 periods) and the length of the time period (one hour) can be varied, or tuned, as a trader sees fit – the effect is to change the responsiveness of MACD to current prices.

Interpretation

When the FADL crosses the SADL, the difference between the two is zero. As the FADL diverges from the SADL, the histogram height grows. MACD posits that a trend has started when the FADL crosses the SADL and the histogram grows rapidly. When the FADL falls below the SADL on increasing histogram height, MACD is calling for a new downtrend. Conversely, an uptrend occurs when the FADL pierces the SADL from below as histogram height rapidly grows. Because the MACD relies on moving averages of moving averages, it tends to be to lag other technical indicators. Traders therefore view it as a confirmation of a trend that may already have been recognized by other indicators.